If you have been trading for awhile, you’ve certainly noticed the growth in exchange-traded funds, also known as ETFs. Not only are these trading tools as popular as ever, but they have also quickly become a leading part of the entire stock trading industry. Over the past year, the trading volume in ETFs has increased substantially compared to the rest of the marketplace.
At the start of 2011, ETFs represented 25% to 30% of the total traded volume in the United States. During the summer months, this percentage leaped to 40% on several days. Not only have ETFs become the dominant trading vehicle, ETF choices have also increased dramatically. NYSE Arca had more than 265 new ETF listings in 2011 alone. Right now, 39% of these ETFs track domestic stocks, 26% are built on international stocks, 14% are commodities and futures, 11% are based on fixed-income assets, and 3% are built on currencies.
Perhaps the funds that cause the most consternation in traders’ minds are the so-called triple-leveraged ETFs. These trading instruments are designed to follow the movement of their underlying assets at approximately three times the underlying rate. For example, if a triple-leveraged ETF follows the S&P 500, the ETF will move approximately 3 percentage points for every percentage point the S&P 500 moves. This leverage can be either a negative or positive force depending on the direction of your trade.
As you can imagine, triple-leveraged ETFs can be a powerful tool for some traders. However, there is a critical caveat for anyone considering trading triple-leveraged ETFs. First and foremost, triple-leveraged ETFs are not recommended for long-term holds. In fact, they are specifically designed to be an intra-day tool because the underlying portfolio of assets needs to be constantly rebalanced to maintain the leverage. This rebalancing incurs fees and costs and can create losses for those who hold the triple-leveraged ETFs overnight, even if the underlying assets move in the right direction. Therefore, it’s important that traders understand holding leveraged ETFs long term is not a good strategy since the rebalancing costs decrease the positive correlation.
ETFs remain extremely popular because they allow traders to access baskets of assets with a single exchange-traded vehicle. They can offer diversification and leverage for sophisticated traders who understand how they work.
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